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Solving The Puzzle Of The Cash

Flow Statement
Julie H. Hertenstein and Sharon MOMcKinnon

he cash flow statement is one of the most from the t-ash flow statement may

T useful financial statements companies


prepare. When analyzed in a rational,
logical manner, it can illuminate a treasure trove
provide.
Analyzing this statement should
not present a formidable task when A Business
of clues as to how a company is balancing its
receivables and payables, paying for its growth,
reviewed in the manner we are advo-
cating here. Instead, it will quickly
Horizons
and otherwise managing its flow of funds. But become obvious that the benefits of tutorial.
many readers seem to bypass the cash flow state- understanding the sources and uses of
ment and head only for the old, familiar, comfort- a company’s cash far outweigh the
able income statement and balance sheet-de- costs of undertaking some very
spite the fact that the cash flow statement may straightforward analyses. Executives
provide considerable information about what is want to know if the cash generated by
really happening in a business beyond that con- the company will be sufficient to fund
tained in either of the other two statements. their expansion strategy; stockholders
There are several reasons why the cash flow want to know if the firm is generating
statement may not get the attention it deserves. enough cash to pay dividends: suppli-
First, although it has been around in its present ers want to know if their customers
format since mid-1988, it is still considered the will be able to pay if offered credit;
“new statement”; many managers were not ex- investors want to evaluate future
posed to it during their business schooling in growth potential; and employees are ,
financial analysis. If they were, they may have interested in the overall viability of
been taught how to prepare one but not how to their employer as indicated by its ability to fund
interpret the story it tells. its operations. These are just a few of the valu-
Second, the format of the “Cash Flow from able insights to be gained from the cash flow
Operating Activities” section of the statement can statement.
be challenging to follow if presented in what is The method we suggest for studying this
known as the “indirect” method. But perhaps valuable statement contains several steps, with
most daunting to many is the mistaken idea that the preliminary step consisting of gaining a basic
it takes a very sophisticated analysis of compli- understanding of the format of the cash flow
cated ratios and relationships to use a cash flow statement. Once a certain “comfort level” with the
statement effectively. structure of the statement has been attained, indi-
Contributing to this notion are numerous vidual companies’ statements should be exam-
business journal articles that have appeared in ined to gain practice in using the stepwise ap-
the past decade. They promote the value of this proach described shortly. These steps consist of:
statement when appropriate cash flow ratios are 1. scanning the big picture;
used in statistical packages, such as those used to 2. checking the power of the cash flow en-
predict bankruptcy. Present day textbooks, when gine;
not merely teaching students to prepare the state- 3. pinpointing the good news and the bad
ment, also concentrate on describing how ratios news; and
such as “free cash flow to net income” can be 4. putting the puzzle together.
derived, but say little about what truly useful Pay attention, for you will be tested on your new
information these ratios or other information expertise at the end of this article!

Solving The Puzzle Of The Cash Flow Statement 69


Format Of The Cash Flow Statement explanation of “direct versus indirect” formats is
provided in Figure 2 for readers who desire
The cash flom~ statement is divided into three more information.
sections: operating activities. investing activities. Regardless of how the cash flo\v from oper:lt-
and financing activities. Figure 1 presents an ing activities section is formatted, it is important
example of a simple cash flow statement with the to remember that this is the most important of
three sections delineatecl in lwld letters. Each the three sections hecause it clescrihes how cash
section shon-s the cash inflmvs and outflo\vs is being generated or wised 13~ the primary activi-
associ:tted with that type of acti\‘ity. ties of the company. To picture activities that
cilsh~ou~,fi-ot?i qbrmtil~g dctilVtic5 show3 the affect cash flow from operations, think of the
results of c:ish inflows and outflo\~z related to the cash receipts :mcl payments that make most
fiindamental operations of the basic line or lines working capital accounts on the balance sheet
of husincss in xvhich the compq~ engages. For increase or decrease. For example, accounts re-
ex;unple, it includes cash receipts from the sale ceivable ciecrcases b\hen cash is collected from
of goods or sen,ices ;inci cwh outflwvs for pur- customers. inventory increases lvhcn goods are
chasing inventory and paying rent 3rd taxes. You purch:isecl. 3rd ;iccounts p:iyaMe decwnses \\hen
uill notice it does not show these items directly. suppliers are l-uid for their goods.
It ;iss~~nics that most of these ash inflows and The next section is called c~~lsh,/l~~rt~,fj.(/t~~
outflo\vs are dready summarized in the “Net ii~~w-tip actiz$ties. Hue you see the c:tsh flo\vs
Income” figure, so it starts at that figure- and associated Lvith purchases 2nd sales of non-cur-
makes an adjustment for everything that is not :I rent assets. such as Iwilding and equipment pur-
true represwtation of “cash in and out” in net chases, or sales of investments or sulMdiaric,s. An
income. This approach is the “indirect format” of easy way to picture what activities W~OLII~lx here
presenting cash flows from operating activities is to think again of a Idance sheet. of WLI LSSLIIIIL
and is the one chosen by most comp:mies. The current assets are associated \?itli operations.
indirect format an he confusing. and 2 longer then the ;icti\rities associated Lvith all the rest of
the assets are in this section.
The third section is called ca.sh,fZolcI,fj.(~???
J~zc~~?ci?zguctir~itics. Again. the I~lance sheet
Figure 1
prr)\~icles 2 handy \\2); of discerning what b~~~~lcl
Statement of Cash Flows
be in this section. If you eliminate the current
liabilities aw~ciateci \\itli operations, then the
Cash Flow from Operating Activities
activities of all the rest of the lial%lities 2nd thy
Net Income.. ...................................... ................................ .......... xxs.xxx stockholders’ equity accounts are summarized
Adjustments to reconcile net income to net c:ish provided 17) hue. These are all the floods associated with fi-
operating activities: nancing the firm, everything from selling and
I~epreciation :rnd amortization .................. .............................. sx.xxx
pa);ing off I~~ncis to issuing stock ad paying
Changes in other accounts affecting operations:
dividends.
(ln~rease)/decre:lse in accounts receivalde .......................... Lxxx
(In~rease)/cle~rea~e in in\witories ....................................... x.xXx
Warning! There are exceptions to everything,
(Inca-ease), decrease in prepaid expenses ............................. x,xxx and the cash flow statement format has a ftw to
In~rease/(decrease) in accounts payihle .............................. x,xXx watch out for. T\VO working capital accounts, one
Increase~(d~crease) in taxes payaIde .................................... ?o(s asset and on? liability, are dealt \\ith outside the
Net cash provided 13). opwting acti\?ties .............................. xsx.xxx cash flo\v from operating activities section. Short-
term marketable securities are treated as long-
Cash Flow from Investing Activities term investments and appear in cash flo\v from
Capital expenditures .................................................................... (xxx,xxx) investing activities: similarly. short-term clelX is
Proceecls from sales of equipment ................................................ xx.xxx treated as long-term debt and appears in cash
Proceeds from sales of in\wtments ............................................... Xx,xXx flow from financing activities.
Investment in sulXidi:uy .............................................................. (xXx,xXx) Another :~nomaly is the treatment of interest
Net ~3511 pro\?cletl 1,). (ubed in) inlwting activities.. ............ (xXx,xXx) and cli\-idends. Although dividends are handled
as a cash outflow in the cash flow from firuncing
Cash Flow from Financing Activities
activities section, interest payments are consid-
Paymrnts of long-term clrlx.......................................................... (xx,xsx) ered an opernting outflow, clespite the tiJct that
I’roceeds from issuanctz of long-trml debt ................................... x\;,xxx both we payments to outsiders for using their
Proccecls from issuance of conm~on stock .................................. xXx,xXx money! In some countries, such as the United
IXviclentls paid.. ............................................................................. (xX,XxX) Kingdom, interest payments are included in the
I’urchse of treasuq stock ............................................................ (xx,xxx)
financing activities section. But in the LJnited
Net cash provided by (used in) financing acti\,ities ............... (xx
A xxx) States. the Financial Accounting Standards I3oard
Increase (Decrease) in Cash .................................................. ... xx&xx (FASI3) voted that interest payments should be in
the operating activities section instead. In such a
situation, one might have to adjust somewhat if Other reports may not contain such “rosy sce-
one were trying to compare it LJK company like narios,” as you will discover shortly.
British Petroleum to a ITS. company like Exxon. Scanning the big picture involves several
substeps. The first is to place your company in
Step 1: Scanning The Big Picture context in terms of its age, industry, and size. We
expect mature companies to have different cash
Now, sit back with your favorite company’s an- flows from start-up companies. and service indus-
nual report and follow these steps to understancl- tries to look different from heavy manufacturing
ing its cash flow picture. You can think of this as industries. Rig corporations may experience de-
a big p~~zzle exercise. All the pieces are there in clining cash flows in certain years, but the sheer
the statement: your task is to put them in the immensity of their cash flows may ameliorate
proper context to form a mosaic from which a concerns, whereas the declining trend might be
picture of the firm’s cash flow health emerges. If much more worrisome if they were small firms
you don’t have an annual report handy, you can without such vast resources.
use Figure 3, which shows the cash flow statc- Colgate-Palmolive certainly qualifies as a
ments for the Colgate-Palmolive Company for the mature company. It is huge (figures are rounded
years ending 1992, 1993, and 1994. We chose to millions), and it operates primarily in consumer
Colgate-Palmolive because it represents one of product markets throughout the world. A firm
the best annual reports in the country and the like this should be involved in complex activities
positive trends are clear for illustrative purposes. on a global scale. Colgate-Palmolive certainly is,
but its cash flow statement is not much more
complex than what one might expect from a
Figure 3 much smaller, perhaps simpler, company.
Consolidated Statements Of Cash Flows: Colgate-Palmolive Continue your big picture scan by flipping
through the annual report to determine ho\\
(1~ nlilliom~ 1994 109.3 IO’)L management believes the year has progressed.
Operating Activities Was it a good year? Perhaps a record-breaking
Net Inco111e s 5x0.2 $ 189.9 s -t77.0 year in terms of revenues or net income? Or is
Adjustments to reconcile net income management explaining how the company has
tc) cash provided by operations:
weathered some rough times?
Cumulative effect on prior years
of accounting changes 358.2 A key part of the big picture scan is to look
Restructured operations, net (39.1) (77.0) (92.0) at a key summary figure of financial health-net
Dzpreci3tion and amortization 235.1 209.6 192.5 income. If the cash flow statement has been pre-
Deferred income taxes :mcl other. net 63.7 53.6 (25.8) pared using the indirect method for operating
Cash effects of these changes: cash flows, as Colgate-Palmolive’s has, you can
(Increase) in receivables (50.1) (103.6) ($+(I) find this at the top of the cash flow statement.
(IncrcaseUdecrease in inventories (44.5) 31.7 28.i Otherwise you’ll have to use the reconciliation of
(Increase)/decrease in other current assets (7.8) (3.6) 10.6 net income and operating cash flows that XCOIII-
Increase/(clecreasr) in p:Lyables 90.9 52.6 (10.0)
panics the cash flow statement, or take a peek at
Net cash provided by operations 829.4 710:: 5+2.7 the income statement itself. What is the bottom
line? Does it show income or losses over the past
Investing Activities few years? Is income (or loss) growing or shrink-
Capital expenditures (100.8) (364.3) (318.5) ing? Keep these points in mind as you examine
Payment for acquisitions (146.4) (171.2) (170.1)
the cash flows. In addition, scan the comparative
Sale of securities and investments 58.4 33.x 79.0
numbers for the past three years for unusual
Investments (1.9) (12.5) (6.6)
Other, net SS.0 61.7 17.4 items you’d like to have explained eventually.
Colaate-Palmolive shows positive net income
Net cash used for investing activities (457.7) (452.5) (397.9) for all three years-a promising start. The three-
year trend appears to be positive, but a big drop
Financing Activities
in 1993 raises a few questions. The statement also
Principal payments on debt (88.5) (200.8) (250.1)
Proceeds from issuance of debt 316.4 782.1 262.6 reveals a few items that need to be checked out.
Proceeds from outside investors 15.2 60.0 In the operating activities section, what is that
Dividends paid (246.9) (231.4) (200.7) “cumulative effect on prior years of accounting
Purchase of treasury stock (357.9) (657.2) (20.5) changes“ in 1993? And what are those “restruc-
Proceeds from exercise of stock options 18.5 21.8 22.6 tured operations”? File those away to examine
Net ash used for financing activities (343.0) (225.5) (1x6.1) later. Note any line items that are vastly different
from year to year. Colgate-Palmolive has a few of
Effect of exchange rate changes on cash (2.9) (6.2) (9.3) those, including changes in its working capital
accounts. the proceeds from issuance of debt,
Net increase (decrease) in cash $ 25.8 $ 26.2 $ (50.6)
and its purchases of treasury stock.

72
Step 2: Checking The Power healthy, growing company, we would expect
Of The Cash Flow Engine growth in operating working capital accounts
such as inventory and accounts receivable as well
The cash flow from operating activities section is as in accounts payable and other operating pay-
the cash flow engine of the company. When this ables. Obviously there can be quite a bit of vari-
engine is working effectively, it provides the cash ability in working capital accounts from period to
flows to cover the cash needs of operations. It period. Streamlining a collections policy or imple-
also provides cash necessary for routine needs, menting a Just-In-Time inventory system could
such as the replacement of worn-out equipment shrink accounts receivable or inventory in a
and the payment of dividends. There are excep- growing company. But on the average, invento-
tions, of course. Start-up companies, for example, ries, receivables, and accounts payable usually
usually have negative cash flows from operating grow in expanding companies. Beware of situa-
activities because their cash-flow engines are not tions in which all working capital accounts in-
yet up to speed. Companies in cyclical industries crease net cash from operating activities. This
might have negative operating cash flows in a likely would not happen randomly in a healthy,
“down” year; a company that has experienced an growing company. It normally results from delib-
extensive strike could also be expected to have erate management action and could indicate a
negative cash flow from operating activities. Al- company in such a cash flow crisis that managers
though occasional years of negative cash flow have been forced to raid the working capital
from operating activities do not spell disaster, on accounts to survive.
the average we should expect it to be positive. With these ground rules, let’s check Colgate-
To check the cash flow engine, first observe Palmolive’s cash flow engine. In all three years,
whether cash flow from operating activities is cash flow from operating activities is greater than
greater than zero. Also check whether it is grow- zero, reaching over $800 million in 1994. It in-
ing or shrinking. Assuming it is positive, the next creases steadily every year, unlike net income.
question is whether or not it is adequate for im- Annual depreciation is in the vicinity of $200
portant, routine expenditures. Just as we do not million each year. and the yearly dividend is also
expect a start-up company to have positive cash around $200 million. Colgate-Palmolive’s cash
flow from operating activities, we also do not flow engine is not only generating enough cash
expect a company still in a very rapid growth to cover “keeping the company whole,” it is also
phase to generate enough cash flow from operat- able to throw off around $400 million annually
ing activities to cover the investments required to for growth and investment, and the amount of
rapidly expand the firm. However, we do expect excess cash has been increasing each year.
the operations of a mature company to generate This is a powerful cash flow engine. A glance
enough cash to “keep the company whole.” This at the working capital account differences indi-
would include the amount of investment required cates that receivables, other assets, and payables
to replace those fixed assets that are used up, have grown (net) over the three years, while
worn out, or technologically obsolete as well as inventories have shrunk slightly. This picture is
cash required to pay the annual dividend share- consistent with a global company increasing its
holders have come to expect. scope through acquisitions and new product
It is difficult to know precisely how much development.
cash is required to keep the company’s fixed
assets “whole,” because the cash flow statement Step 3: Pinpointing The Good News
does not separate capital expenditures for re- And The Bad News
placement and renewal from those for expansion
and growth. However, the annual depreciation This step involves looking at the total cash flow
amount provides a very rough surrogate for the statement to find where the rest of the “good
amount of fixed assets that need to be replaced news” and “bad news” lie. What you are looking
each year. In periods when prices are rising, the for is the story the statement is trying to tell you.
cost to replace assets should be somewhat It will not come simply by divine revelation, but
greater than the cost of older assets that are be- by systematic observation of the items on the
ing depreciated. So to ensure that the firm is kept statement and their trends over the years pre-
whole and is not shrinking, we should expect the sented for your comparison.
portion of investing activities related to the pur- Begin with cash flow from investing activi-
chase of fixed assets to exceed depreciation. ties. What is this section trying to tell you? One
Important information about the cash flow systematic observation is to check whether the
engine is also revealed by examining the operat- company is generating or using cash in its invest-
ing working capital accounts. In the Colgate- ing activities. Whereas we expect positive cash
Palmolive operating activities section, these are flow from operating activities, we also expect a
shown under “cash effects of these changes.” In a healthy company to invest continually in more

Solving The Puzzle Of The Cash Flow Statement 73


plant. equipment, land, and other fixed assets to Nevertheless. it might be worth another more
replace the assets that have been used up or have detailed look if we Lvanted to consider whether
Income technologically obsolete, as well as to continued borrowing provides a likely source of
expand and grow. Although companies often sell funds for future growth, or whether the firm is
assets that are no longer of use to them, they nearing its debt capacity.’
would normally purchase more capital assets A second systematic step in uncovering the
than they sell. As a result. we generally expect news in this section is to check the activities in
negative cash flows from investing activities. As the stock accounts. Colgate-Palmolive is not issu-
with operating activities, exceptions do occur. ing much stock; instead. it seems to IX buying
especially if the firm divests a business or subsiti- back suhstantinl amounts of treasury stock. In
iaq.. However, watch for comp;mia that are IX- fact, that is the single largest use of cash outside
ginning to shrink suhstanti;llly because they are of capital expenditures.? This is prolxlbly a “goocl
generating much of their cash by selling off news” scen:trio, because the company may be
chunks of the business! cashing in on what it considers a low price for its
Colgate-I’alrnolive exhibits the signs of 2 stock, or perhaps protecting itself from takeover
“god news from investing activities” company. attempts. In either e\rent, Colgate-l’almolive al’-
Capital expenditures are nearly 1.5 times the pears to have sufficient cash available to make
amount of depreci:ltion, so they are clearly at a this large. non-routine investment. A little digging
level well beyond that required to keep the com- in the rest of the financial statements might
pany ~c-hole. In addition, Colgate-I-‘almoli\:e makes present the ~~+ole story.
significant expenditures for acquisitions in each
year--another growth indicator. These numl,ers Step 4: Putting The Puzzle Together
remain consistent or increase from year to yeal
:ind paint a picture of 2 steaclil\. growing con- In evaluating the cash flow statement, you are
pany, Lvith enough cash flo~v from operating evaluating many pieces of evidence to produce
activities to cover these exp”nditures and more. an overall picture. Ho~vever, it would be rare to
Cash tl0w.s from financing activities could 3s find 2 company in Lvhich all of the e\?cience is
easily be positive as negative in ;I healthy con- positive, or in Lvhich all of the evidence is nega-
pany. Moreover, they ;Irv likely to change back tive. To make a Idanced evaluation, you must
and forth, so finding the “good” and .‘haci” is use both the good news and the bad news iclenti-
more challenging. It requires viewing the cash fied in each section of the statement. To reach XI
flo\vs from financing :icti\ities in conjunction overall conclusion. you need to judge the relative
\vith other information on the cash flo\v state- importance of each piece of evidence and assess
ment and basing your conclusions on the weight its relationship to the overall picture. As in 3 leg11
of the evidence and your own judgment. Assume case, your conclusion needs to 1x2 based on the
:I company has borrowed cash or issued stock. A “weight of the c\?dence.”
“good news” scenario might be that the firm has Before proceeding with the overall evaluz
carefully andyzed its le\~er:ige and cost of capital tion, one loose end to tie up at this point might
2nd chosen to finance itself through d&t or ecl- be any unusual line items you spotted in your
uity rather than from cash from operations. An- scan of the big picture. Sometimes these demancl
other “good ne~vs” scenario might he that a nem that you ask an expert. but frequently you can
start-up is doing ~vell enough to issue an Initial think them through or search for illumination
Puldic Offering. On the other hand. a “bad nexus” elsewhere in the annual report. Earlier we iclenti-
scenario might he that the company has low (or fied two umlsunl line items for Colgate-1’:iliiiolivc.
negative) cash flows from operations and is l>eing One was the “cumulative effect on prior years of
forced to generate funds from other sources. You an accounting change” in 1993. Without the cle-
must look at the entire package to evaluate duction of this $358 million item from income in
whether your cash flows from financing are in 1993, Colgate-1’~~lmoli~~~ had ;t healthy income
the “good news” or “id news” categories. figure of $548 million; but after sulXracting it.
One systematic way to begin is to compare income fell to S190 million. The explanation is
borrowing and payments on debt with each other that when Colgate-1’3liiiolive made this account-
across the years and note the trends. Colgate- ing change. all of its effects prior to 1993 were
Palmolive has been consistently borrowing more charged to income in 1993. In reality, there was
than it has paid back. and to a vciy substantial no actual expenditure of cash in 1993, which is
degree in 1Wlj. Good news or laid? We have why we addecl this back on the cash flow state-
already seen the incredible amount of cash being ment.’ This is good to know, l~cause if we ig-
thrown off from operations. so this increase in nor2 the accounting change and the associated
clebt financing is probably the result of 3 con- charge. net income has steadily increased.
scious management decision and not the actions The other unusual line item was alled “re-
of a company desperately borrowing to survive. structured operations,” which Colgate-Palmolive
subtracted from net income. This means that the annually, an expression of management’s confi-
cash flows associated with restructuring opera- dence in the firm’s future cash-generating capa-
tions occurred in a different year from when bility. It also has sufficient excess cash to repur-
these costs were expensed on the income state- chase large amounts of its stock.
ment. In all three years presented by Colgate- Now the bad news. The presence of charges
Palmolive. it had more cash outflows for restruc- for “restructured operations” indicates that
turing than it expensed in the income statement. Colgate-Palmolive has experienced problems in
Good news or bad news? When a company some portions of the business. It has borrowed
restructures some of its operations, there is both. significantly, in excess of repayment, which could
The bad news is that there was some kind of increase leverage. The repurchase of stock could
problem that required the restructuring. The good indicate management concerns with possible
news is that the company recognized the prob- takeovers. And acquisitions somrtimes create
lem and took action it hopes will be effective. problems for firms; it is difficult to integrate them
Whether the restructuring cash costs are more or successfully into the company’s business to en-
less than the restructuring expense is simply a sure adequate returns.
timing issue. Because expenses are recognized as The good news in the Colgate-Palmolive cash
soon as reasonably possible, it typically requires flow story is quite compelling. The bad news is
several years after the expense has been recorded more at the level of “concerns” rather than major
for all of the cash costs to be incurred. Colgate- cash flow problems. So considering the weight of
Palmolive probably recognized these restructur- the evidence, Colgate-Palmolive appears to have

ow
ing expenses in prior years and this is just the a strong positive cash flow story.
anticipated cash outflows catching up with them.

N
Moreover, the amount on the cash flow statement it’s your turn. The best way to learn
is declining each year. about cash flow statements is to study
Whether or not to chase down explanations some carefully using the four steps
for unusual or unknown items is a subjective call. described above. You may not become an expert
For example, if Colgate-Palmolive’s restructuring but you will be able to spot the big trends and
charge differences were bigger or growing, it important issues involved with the management
might be worthwhile to search for more informa- of cash in most companies.
tion. However, the “weight of the evidence” so Figure 4 provides you with the opportunity
far indicates that this issue is not particularly rel- to test your newfound skills. It is similar to the
evant in getting at the big picture. If you encoun-
ter something you do not understand, consider its
materiality. If it has a major effect on cash flow Figure 4
from operating activities, or if it ranks as one of Jones Company: Statements of Cash Flows
the major sources or uses of cash, you should For Year Ending December 31
probably search for an explanation. Otherwise it
may be more efficient to ignore it and concen- Millions of Dollu~.s 7005 1994 19%
trate on the many items you know. Cash Flow from Operating Activities
Net income (loss) S (43) $ (189) $ (134)
Now let’s summarize what we’ve learned by
Depreciation 230 271 350
examining Colgate-Palmolive’s cash flow state-
(Increase) in receivables (121) (25) (4)
ment. First, the good news. Net income has been
LIecrease in inventories i0 42 30
positive for all three years and, if we eliminate Changes in other current accounts _l& llil (12)
the effects of the accounting change, has been
steadily increasing. Operating cash flows have Net cash provided by operating activities 132 91 230
also been positive for three years; they, too, have
Cash Flow from Investing Activities
been steadily increasing. Operating cash flows
Capital Expenditures (200) (260) (310)
have significantly exceeded the sum of deprecia- Disposal of plant assets 204 200 180
tion and dividends, so Colgate-Palmolive is gen- Disposal of business segnwnt m L!
erating enough cash from operations to expand
Net cash (used in)/provided 1,);
the business. The working capital accounts are
investing activities 138 (9) (120)
growing, consistent with the expectations for a
growing business. By making capital expendi- Cash Flow from Financing Activities
tures that significantly exceed clepreciation, and Pro~ercis of long-term debt 200 450 215
also by making fairly large acquisitions, Colgate- Reductions of long-term debt (460) (480 1 (322)
Palmolive shows that it is grooming the business Dividends paid (30)
for the future. There are no large-scale sales of
Net cash used for financing activities (260) (SO) (137)
fixed assets or divestitures that indicate any
downsizing or shrinking of the business. The Increase (decrease) in cash $10 $ 52 $ (27)
company has increased its dividend payments - - -
puzzles you encountered as a child in which YOLI changed as ;I percentage of total liabilities and stock-
spot the things that are wrong with the picture. holders’ equity? For Colgate-Palrnoli\,~, the percentage
Poor Jones Company is having some rough times, of debt to tc)tal IiabiliGes and stockholders’ equity is
as illuminated by their cash flow statements for quite high and has gotten higher, from 6% in 1993 to
70% in 1994. The company‘s income alrement reveals
1993, 1994 and 1995. See how many of these
that interesr expense has almost doubled in the last
troubling developments you can identify by put- year, and ;I quick ratio analysis of “nunher of timrs
ting together the PLIZZ~ of the Cash Flow State- interest can he paid from income” shows 3 slurp de-
ment! (Some possible answers are listed at the cline from 7 time to alwut 4-l/2 times in one year.
end of the article.‘) Furthrr examination of rhe cash tlou, statement reveds
Opportunities for applying your new exper- that rhe comp;iny purchased large amounts of treasuq
tise are many. As an employee curious about stock. This helps explain why stockholders’ equity is
your company’s ability to cover your paycheck, low in comparison to total equities. \vhich may make
you can check out the health of cash flow from that 700/o dcht-to-total equity ratio more unclerstancl-
:hle.
operating activities. Or suppose you are 3 seep-
2. This contrasts \\ith minor stock repurchases that
plier \vhose customer has just announced ;I loss
companies rypically undertake to offer stock to cnl-
for the year and you are a~ondering whether to
ployees in stock option plans: in such instances, mod-
continue to extend credit. An analysis of the est treasury stock repurchases are offset by modest hut
customer’s cash 1-10~ from operating activities can comparal)le issuances of treasury stock.
provide you \vith evidence that the firm does 01 3. An accounting change is just 2 “paper decision”;
does not have strong enough cash flows from it affects the \v;iy net income is presented. hut ir does
operating ac‘tivities to pay its bills despite losses not change the tundamenral economic activity of the
on the income statement. firm. so it ciocs not affect cash receipts or c:Lsh expe”-
If you are a stockholder. you may be inter- ditures.
ested in \vhether cash flow from operating activi- -t. Some possilde :ms\Yers are: ( 1) there have lwen
losses in all three years: (2) depreciation charges have
ties is large enough to invest in the capital expen-
decreased: (3) capital expenditures :ire Irss than clepre-
ditures required to keep the company whole and ciarion; (4) capitd expenditures are less than disposals;
make it grow while still paying the dividend you (5) ;I big :iccounts receiv:lble increase needs to be
have come to expect. As an executive. you might invcstigatecl; (6) in\,entories are decreasing: (7) seg-
examine the ash flo~v statement to determine ments of the business :ire being sold off; (8) the com-
whether it is likely that all of the major sources of pany has stopped paying dividends; (9) debt needs to
cad-operating activities. issuing stock. and I,e paid off with cash flow from operations; (10) there
I2orrowing-wdl be sufficient to fund 3 major is mucli borro\ving; ( 11) there is less I>orro\ving this
expansion progl-am ~OLI plan to Ldertake. As ).ear. Are creditors trusting the comp:lny less?
your expertise increasc5, many 0dWr useful appli-
References
cations may appear to you.
The information contained in a cash flow
statement cannot repLice the information from
the traditional income statement and Mance
sheet. But it does provide v:il~lahle input for un-
derstanding the relationships between income
and its short- and long-term ability to generate
cash. 0

Notes

I, This might Ix the time to go looking for clues


in the rest of the annual report. Where to look:’ A Julie H. Hertenstein is an associate pro-
homote on long-trrm del~r might seem logicd, but it is fessor of business administration at North-
often almost impossil,le to wily understand unless you eastern University, Boston, Massachusetts,
are a Chief Financial Officer. Easier 2nd s0metime.s where Sharon M. McKinnon is a professor
more illumin:lting is to do some simple ratios On the of business administration.
balance sheet and income statement. How has debt